Question

Discuss portfolio theory and why diversification is a good thing for investors?

Answer 1

Portfolio Theory suggest that we should include different type of assets in our portfoilio to maximize the expected return at a given level of risk. We must not put our fund in one type of asset or securities. Risk must be diversified by investing our fund into different asset class like stocks, bonds, pension fund, real estate, gold etc.

Portfolio Theory is based on the variance and correlation. We must find out the correlation between different class of asset. We must include the assets which are negatively correlated. If the return on asset 1 falls, asset 2 return rises. Thus, it will reduce the risk of loosing all our funds as investing in same asset class. We must avoid the positively correlated assets which moves in same direction. By including more of negatively correlated assets will result in low volatility and high expected return. Diversification helps in reducing the overall risk of the portfolio with optimizing the expected return.